Aug. 30 (Bloomberg) -- The $3.7 trillion municipal market
is poised to recover from the worst August since 2007 as cash
flowing to investors from maturing or refinanced local-government debt eclipses the sale of new bonds.

Munis have returned about 0.1 percent since July 31, the
least for August in five years, Bank of America Merrill Lynch
data show. The market earned 1.5 percent in August on average
from 2001 to 2011, the most for any month. Yields on tax-exempts
and Treasuries rose earlier this month as concern eased that
Europe’s debt crisis was deepening. Local debt also suffered as
new supply exceeded bond calls and redemptions by the most since
2010.

The tax-free debt rebound may already be under way.
Benchmark 10-year munis are gaining a second straight week as
issuance slowed to the least this year for a non-holiday period.

“I expect September to be a better month than August,”
said Vikram Rai, a muni strategist at Citigroup Inc. in New
York. “We had expected a temporary backup in yields in August”
in part because of positive net issuance, he said.

Tax-free debt started the month with yields close to record
lows. The market has still gained 1.8 percent since June 30, on
pace for a seventh-straight quarterly gain, the longest since
2001.

Reversing July

Helping fuel the rally, investors received a historic wave
of $142 billion from maturing and refinanced muni debt in the
three months through July, according to Citigroup. August
reversed that pattern, with local-government sales exceeding
cash from bond calls and refundings by $12.3 billion, the most
since December 2010.

Issuers from Maryland to Minnesota combined to offer about
$31 billion of long-term munis in August, up about 33 percent
from July, data compiled by Bloomberg show.

The market’s performance may improve in September as
Citigroup forecasts a return to negative net supply, by a margin
of $1 billion.

The descent in yields in July prompted “rate shock” for
individual investors, Rai said. They will shun the market if
yields fall short of their investment goals, he said.
Individuals own about 70 percent of the market either directly
or through money-market funds and mutual funds, Federal Reserve
data show.

How Low?

“I was a little bit surprised early in the month that
munis weren’t repeating that strong performance,” said Kathleen
McNamara, a municipal strategist in New York at UBS Wealth
Management, which oversees about $90 billion in local debt.
“You had a very strong July. People thought: ‘How much lower
can yields go?’”

Yields fell across most muni maturities yesterday. Interest
rates on top-rated tax-exempts due in 10 years fell 0.02
percentage point to 1.78 percent, the lowest in about two weeks,
data compiled by Bloomberg show.

While individual investors have added money to muni mutual
funds for 19 consecutive weeks, last week’s $436 million gain
was the smallest since June for a non-holiday week, Lipper US
Fund Flows data show.

The yield on 10-year federal notes touched a record low of
1.379 percent last month, data compiled by Bloomberg show.
Interest rates on benchmark AAA 10-year munis fell to 1.63
percent on July 27, the lowest since at least January 2009,
according to a Bloomberg Valuation index.

Treasuries have lost 0.5 percent this month, while
corporate bonds are little changed, Bank of America data show.

“You could spend all your time looking at the muni market
and slicing and dicing it, but the bottom line is you can’t
divorce yourself from the bigger rates picture,” said John
Dillon, chief muni bond strategist in Purchase, New York, at
Morgan Stanley Smith Barney. The company oversees about $150
billion in local debt.

Following is a pending sale:

ARKANSAS is set to issue $225 million of general-obligation
bonds as soon as next month, data compiled by Bloomberg show.
The bonds are secured by Federal Highway Grant Anticipation and
Tax Revenue and will help finance interstate highways, according
to bond documents. (Added Aug. 29)